Depreciation of like-kind exchange property after Notice 2000-4.

• Author: Mason, J. David

Notice 2000-4, on the treatment of depreciation of modified accelerated cost recovery system property received in a tax-deferred exchange, is generally viewed as taxpayer-favorable. However, an analysis of the provisions suggests a need for careful planning when effecting a like-kind exchange, to maximize the benefits and avoid the many tax traps.

Notice 2000-4(1) explains the treatment of depreciation on modified accelerated cost recovery system (MACRS) property received in a tax-deferred exchange under Sec. 1031 or involuntary conversion under Sec. 1033. The notice, while welcome, requires careful planning when effecting like-kind exchanges, to optimize the benefits and avoid the burdens.(2)

Background

The like-kind exchange has become a popular tax-deferral strategy for converting assets with built-in gain into other, similar property better suited to a taxpayer's needs. Sec. 1031(a) provides that, generally, no gain or loss is recognized on an exchange of property held for business or investment use solely for replacement property held for business or investment use.

In lieu of recognizing gain on the transaction, Sec. 1031(d) provides that a taxpayer takes a carryover basis in the replacement property (i.e., a taxpayer's basis in the replacement property equals his basis in the relinquished property). The basis of the new property (new basis) is increased to the extent of any boot paid or decreased to the extent of any boot received. The new basis is used in calculating any gain or loss on the property's subsequent sale.

This rule applies regardless of whether the properties involved are subject to depreciation. Because the basis of depreciable property carries over to the replacement property, an issue is whether a taxpayer should be allowed to use the relinquished property's depreciation method and schedule for replacement property, or must begin anew.

Pre-Notice 2000-4 Rules

For transfers prior to the Tax Reform Act of 1986 (TRA '86), Sec. 168 provided that any property placed in service after 1980 had to be treated as new property for depreciation purposes, regardless of how acquired. However, Sec. 168(f)(7) provided that future regulations would govern depreciation in property exchanges not subject to tax (e.g., like-kind exchanges). Prop. Regs. Sec. 1.168-5(f)(2)(i), issued in 1984, provided that to the extent a taxpayer's basis in the new property was determined by reference to the basis in the transferred property, the taxpayer would continue to depreciate the property received in the exchange as if it were the transferred property; any excess basis would be treated as new property for depreciation purposes.

However, the TRA '86 overhaul of Sec. 168 did not retain Sec. 168(f)(7); thus, Treasury's authority to promulgate the exception terminated and the proposed regulation was withdrawn. For like-kind exchanges after 1986, there was no longer statutory authority allowing a taxpayer to continue to depreciate replacement property as the relinquished property, and excess basis as new property. This suggested that the replacement property had to be treated as new property for depreciation purposes.(3)

Example 1: X purchased a warehouse in January 1987 for $20,000,000 and depreciated it under the 31.5-year straight-line method. In 2000, X entered into a like-kind exchange of the warehouse for an orifice building. X's remaining basis in the warehouse became his basis in the office building. However, instead of being allowed to depreciate such basis over the remaining life, 18.5 years (31.5 years - 13 years), X is required to treat the building as a new asset and depreciate it over 39 years.

This approach can have a particularly harsh, result, because X would effectively be depreciating a portion of the basis (approximately $11,700,000 of the warehouse's original cost) over 52 years (39 + 13) rather than 31.5, an additional 20.5 years. If instead, X had exchanged residential realty (27.5-year life) for non-residential realty (39-year life), he would depreciate the remaining basis over an additional 24.5 years, not 20.5.

Thus, the type of property relinquished and its holding period before the exchange effect the tax results. In Notice 2000-4, the IRS adopted a taxpayer-favorable position to help mitigate this outcome for property acquired after 1986.

Notice 2000-4

Transfers of MACRS Property after Jan. 2, 2000

Notice 2000-4 states that, for acquired MACRS property placed in service after Jan. 2, 2000, in a like-kind exchange of MACRS property under Sec. 1031 or as a result of an involuntary conversion of MACRS property under Sec. 1033, a taxpayer must follow the principles set out in the notice. Further, Treasury will issue Sec. 168 regulations to address these issues; taxpayers are directed to rely on the notice until regulations are issued.

According to the notice, acquired MACRS property should be treated in the same way as the exchanged or involuntarily converted MACRS property, to the extent the taxpayer's basis in the acquired MACRS property does not exceed his adjusted basis in the exchanged or involuntarily converted MACRS property. Thus, the acquired MACRS property is depreciated over the...